AUDITING IN THE PUBLIC INTEREST”
NEWSLETTER, SPRING 2005

ARE YOUR INTERNAL CONTROLS OPERATING EFFECTIVELY?

Ever since the downfall of large national and international companies such as HIH, Enron and WorldCom, the accounting and legal profession has been the centre of a lot of attention from legislators and professional bodies seeking to provide assurance to the community that financial management and reporting standards deserve continuing trust. Responses in the USA were the enactment of the Sarbanes Oxley Legislation in 2002 and CLERP 9 in 2004 in Australia.

Parallel initiatives in the accounting profession have among other things focussed around improved accounting and financial reporting standards – the adoption of International Accounting Standards and a steady stream of changes to global auditing standards. Indeed, almost all auditing standards in Australia have been subject to change over the last 2 years.

Whilst many of the changes in auditing standards won’t manifest themselves all that differently at the client level some do, particularly those around requirements for the auditor to assess the control framework – the control environment, risk assessment, information and communication, control activities and monitoring of those controls. Other standards require the auditors to pay considerably more attention to the broad assessment of the risks in organisations and the manner in which the organisation itself manages those risks including fraud risk.

These important changes to auditing standards will in the future, see auditors asking much more searching questions around risk management, the control environment, the effectiveness of fraud management strategies, and the general culture of ethical behaviour in organisations.

It would be a mistake for the public sector to see itself differently to the private sector in this regard. A recent lecture address by Professor Larry Crumbley at the University of Melbourne on the subject Corporate fraud and financial abuse; the current and future role of forensic accounting traced the evolution of auditing over the last 100 years. He suggested that the influences of the events referred to earlier have precipitated a turning point in how those that are responsible for the management of organisations, and those who audit them, will need to address their responsibilities in the future.

His is a timely reminder that on average between 5-6 per cent of all income in organisations whether they are private or public sector bodies is lost through fraud and of that amount a large proportion is lost through fraud committed by those within the institution. Over 90 per cent of frauds involve asset misappropriation. The average length of a fraud is 18 months and the most common way of detecting occupational fraud is through tips from employees, customers or other sources. The second most common way of detecting fraud is through an effective internal audit function. The third is by accident.

A number of reported frauds in the public sector in recent times highlight the reality that fraud will tend to occur in almost any organisational setting. Effective deterrents for reducing the risk of fraud occurring include, maintaining effective internal controls, responding to queries that come in, ensuring that regular control activities such as reconciliations are conducted promptly and thoroughly, maintaining an appropriate ethical tone within the organisation starting from the top down and ensuring that people take their annual holidays.

For their part, you could expect that auditors will from now on ask questions they might not have asked in the past – revised audit standards explicitly require a greater degree of randomness in the nature of audit tests undertaken, and in more explicit verification by the auditor of explanations given in answer to audit queries.

There is a growing body of literature which helps both managers and auditors assess the quality of the control environment and to gauge the degree of risk that occurs in organisations where these unfortunate practices might occur. Undoubtedly this is likely to lead to increasing costs for the audit function both internal and external. However, if one was to apply the percentage referred to earlier, it is easy to recognise that the costs of not paying attention to these matters is far greater than the additional cost of the audit expanding its range of interests. If you were a private sector body, the multiplier effect of allowing fraud to occur unchecked is such that for that institution to make up for a 6 per cent loss of profit it must increase its revenue turnover by an additional 20 per cent!

Bearing the above comments in mind, I am pleased to observe that there has been a substantial improvement in the effectiveness of audit committees in Victorian public sector bodies over recent years. Those that I have attended undertake their duties diligently and, in most cases, are having a very positive, professional and disciplined effect on the way organisations undertake their resource and financial responsibilities.

Both effective management and effective audit committees provide the best way in which to manage ongoing business risk.

Wayne Cameron

Auditor-General

RECENT REPORTS TABLED IN PARLIAMENT

Managing stormwater flooding risks in Melbourne (2005:8)

Severe storms across Melbourne in December 2003 and January 2004 resulted in widespread flash flooding in some metropolitan areas, with consequential disruption of services and property damage. These events highlighted the flooding risks for those parts of Melbourne developed before the late 1970s with lower drainage capacities.

Our report, Managing stormwater flooding risks in Melbourne, was tabled in parliament on 19 July 2005. The report examined the performance of Melbourne Water (the city’s central water and drainage authority) and 6 councils (Bayside, Boroondara, Darebin, Casey, Glen Eira and Stonnington) in managing their stormwater drainage systems to effectively mitigate the risk of overland flooding.

The audit concluded that aside from 2 agencies (Melbourne Water and Stonnington), there was little evidence that effective strategies had been applied to address the flooding risks. Because of this lack of progress, metropolitan Melbourne will continue to face significant flood-related damage, particularly to properties located in flood-prone areas, should the storms as severe as those of 2003 and 2004 recur.

All 7 agencies that were covered in the audit supported the report’s 11 recommendations including that they collaboratively address flooding risks.

Flooding in Glenferrie Road, Hawthorn, in early 2004.

Managing intellectual property in government agencies (2005:9)

Intangible assets and intellectual property (IP) are increasingly important in today’s economy. Government agencies deal with many different kinds of IP, for example, scientific research, information technology solutions, information datasets such as global information systems (GIS) and social research.

The ineffective management of IP poses a number of risks to organisations, including risks of liability and of lost opportunities. This audit considered whether selected government agencies effectively manage their IP assets.

Intellectual property includes copyright material, trademarks, patents, registered designs, plant breeder’s rights, circuit layouts and confidential information. It is currently managed without a whole-of-government policy framework. The guidelines in existence relate to copyright only; however, several agencies currently use the guidelines on copyright to support their approaches to managing other, non-copyright IP.

There is currently little proactive management of IP in the agencies examined - many take a default position that the state must own all IP created under funding agreements or through purchasing contracts. IP is routinely vested in the state through the use of clauses in contracts and agreements without any analysis of whether significant IP will be created. We found there is little analysis of whether other access models, rather than state ownership, would promote better project or organisational outcomes.

There is little in place to ensure that agencies are aware of IP owned under agreements, or have established mechanisms to facilitate use and access. Monitoring of contract and funding agreement terms relating to the creation and use of IP is weak. This leads to a tendency for IP to be “locked up”, and therefore it is less likely that it will realise its full potential as a public asset.

East Gippsland Shire Council: Proposed sale of Lakes Entrance property (2005:10)

In February 2004, the East Gippsland Shire Council requested my Office to examine the adequacy of its processes and actions in attempting to sell the property at 55 Palmers Road, Lakes Entrance, and in settling an associated legal action.

The council was unsuccessful in selling this property in the period between 1998 and 2001. In June 2001, it resolved to sell the property for $1.5 million to a private company. Following community unrest and a number of other offers for the property, the council decided not to proceed with the sale, but sell the property by public tender. In October 2001, the council approved the sale of the property for $1.525 million. Subsequently, an interested party initiated a Supreme Court action to prevent the sale.

In October 2003, the council settled the Supreme Court action at a cost of $912 000, and the contract of sale for the property was cancelled.

Our report identified a number of deficiencies in the council’s processes and actions, including:

• lack of evidence that a comprehensive analysis was undertaken prior to pursuing the sale of the property

• inadequate due diligence on prospective purchasers of the property

• poorly conducted tender process for the sale of the property which was further compromised by the actions of the then mayor

• lack of transparency to the community and inadequate community consultation

• deficiencies in advice from council officers to the council.

The report drew out a number of important lessons from the events surrounding the sale of the property which should be considered by all local governments when planning the disposal of significant public assets. It also identified opportunities for further guidance to be provided to local government in Victoria.

Franchising Melbourne’S train and tram system (2005:11)

The lifeblood of any great city is its public transport system. It connects people to work, services and each other.

For over 100 years, Victoria’s train and tram system was provided by the state. In 1999, the (then) Victorian Government split Melbourne’s train and tram system into 5 franchises, and awarded them to 3 private sector franchisees for periods of between 12-15 years.

However, it soon became clear that some of the franchisees’ revenue and cost targets had been unrealistic and were unsustainable. This jeopardised their viability. By December 2002, the franchisees’ financial difficulties had become acute, and one (the National Express Group Australia) withdrew from its 3 franchises. The government immediately appointed receivers and managers to operate these 3 businesses. It also negotiated interim operating agreements with the 2 other original franchisees, while it considered its options for the whole system.

After a detailed process (the subject of this audit), the government restructured the metropolitan train and tram system into one train and one tram franchise, and awarded the 2 current franchises to: Connex Melbourne Pty Ltd (train franchise); and MetroLink Victoria Pty Ltd (tram franchise).

Unlike in 1999, the government did not award the current franchises through a competitive tender process. Instead, it chose to negotiate bilaterally with Connex Melbourne Pty Ltd and MetroLink Victoria Pty Ltd. (These franchisees are referred to as Connex and Yarra Trams respectively for the remainder of this article).

The current franchise agreements commenced in April 2004 and will end in November 2008, with an option to extend the franchises till May 2010. The Department of Infrastructure (DoI) manages these franchise agreements for the government.

The objective of this audit was to determine if the 2004 franchising agreements for the metropolitan train and tram system represented value- for-money. In particular, the audit sought to determine whether:

• the responsible agencies effectively managed the process of developing the current franchise agreements, so as to ensure value-for-money

• the 2004 franchise agreements adequately took account of the lessons learnt from the 1999 franchise agreements.

Our overall conclusion is that the current train and tram franchise agreements represent reasonable value-for-money (assuming that franchisee performance meets contracted levels). This conclusion is principally based on our assessment that the payments the government negotiated with the train and tram franchisees were close to the best possible prices it could have negotiated for the sustainable operation of the metropolitan train and tram system.

DoI’s primary negotiation strategy was to develop and use train and tram public sector benchmarks to accurately identify realistic costs and revenues of Melbourne’s train and tram franchises: in short, the benchmarks helped DoI (and the government) become a highly informed purchaser. The benchmarks are discussed in detail in the report, along with DoI’s other, complementary negotiation strategies.

Having said this, DoI took a conservative approach to allocating risks in the current franchise agreements, resulting in several risks returning to the state. This was principally to ensure that the current agreements would be more sustainable than the original agreements. While this was an understandable reaction to the difficulties experienced in 1999, the approach undertaken to allocating risks in the 2004 agreements may diminish the benefits for government of outsourcing metropolitan public transport operations. In future arrangements for the metropolitan train and tram system, there may be an opportunity to increase value-for-money to the state by allocating some risks back to train and tram operators.

In addition, DoI put in place a range of mechanisms to ensure the sustainability of the current agreements. The most far-reaching of these measures is a comprehensive performance monitoring framework.

This transaction has served as a valuable test of the principles embodied in the government’s approach to procuring services through public-private partnerships – in this case, for public transport services. The lessons learnt should be helpful for other similar transactions in the future. However, the government’s generic guidelines for procuring services through such transactions may need to be tailored to reflect individual circumstances. It is, therefore, important that the guidelines are continuously reviewed to ensure they reflect past experiences, and to ensure their relevance in future transactions of this nature.

DoI provided some detailed responses indicating how it will take up the report’s findings and recommendations.

A new low-floor tram, the Citadis tram, operated by Yarra Trams.

Results of special reviews and other investigations (2005:12)

This report contained the results of 3 recently completed audit investigations and 2 special reviews.

The audit investigations examined the validity of a number of significant allegations and concerns conveyed to my Office by external parties, about:

• the tender and administration of a major contract for the supply of water treatment chemicals to the Barwon Region Water Authority

• the management of a tender by the Kangan Batman Institute of TAFE of its printing functions

• the possible misuse of court funds at the Geelong Magistrate’s Court.

The special reviews examined:

• the operation of the Regional Infrastructure Development Fund (which is administered by Regional Development Victoria), and the adequacy of systems and processes established to monitor, evaluate and report on the outcomes of projects funded from it

• how well 5 local governments administered grants (including various forms of financial assistance) provided to third parties.

The report identified opportunities for improvement in each of the areas examined, and made recommendations to strengthen the audited agencies’ practices and performance.

A number of the issues canvassed in the report are common to public sector agencies, for example the tender and administration of contracts, and the administration of grants programs. Recent audits of tendering activities have led to the identification of the need for further audit attention in this area of public administration. This concern has been reflected in our 2005-06 work plan, where a broader study of tendering and contract management practices is scheduled for later this year.

Health procurement in Victoria (2005:13)

Goods and services constitute the second largest cost in the health sector – second only to payroll. Victoria’s public hospital’s and health services spend some $1.6 billion each year on goods and services. The effective management of these costs is therefore an important element of any strategy to run hospitals efficiently and effectively.

In mid-2001, a procurement model was created in Victoria aimed at providing hospitals with the economies and benefits that could come from purchasing high volume supplies at lower prices through a central purchasing facility. Hospitals retained the flexibility to buy locally where central contracts were not in place or planned. To this end a central procurement agency, Health Purchasing Victoria (HPV), was created in July 2001.

Public hospitals spend around $300 million a year on pharmaceuticals.

Our report, Health procurement in Victoria, tabled in parliament on 5 October 2005 examined the extent to which the activities of public hospitals, health services and HPV had delivered savings and other benefits in procuring health goods and services since then.

We found that while central procurement has clearly delivered savings to hospitals in terms of better prices for goods it has not delivered all the anticipated benefits. Hospitals have also made savings by introducing their own procurement initiatives. But generally they have a way to go before their procurement activities can be considered best practice.

Moving forward we reported that hospitals need to build on their current procurement initiatives to further harness efficiencies and improve their effectiveness. We observed that after 4 years of operation, it is timely to review the procurement model to determine whether it is meeting the needs of the sector and whether all parties involved, i.e. the Department of Human Services, hospitals and HPV, are contributing adequately to the delivery of better outcomes.

Responses by agencies covered in the audit supported the recommendations. HPV considered that the recommendations provide valuable guidance in developing its future strategic directions.

Community planning services in Glenelg Shire Council: 1998-2005 (2005:14)

Planning for the future of a community is arguably a council’s most important responsibility. Planning decisions shape communities and impact on their quality of life and local environments. They affect peoples’ livelihood and amenity. The consequences of these decisions are around for a very long time.

Our report examined Glenelg Shire Council’s community planning activities, following concerns expressed about the quality of its processes and decisions. The impact of council decisions on the conservation and protection of significant state and local cultural, historic and environmental assets were the basis of many of the concerns.

Selection of newspaper headlines
outlining concerns with the council’S planning services.

We found serious deficiencies with council’s delivery of its planning services including:

• inappropriate notification or advertising of development proposals

• failure to refer development proposals to government agencies and bodies for feedback

• approval of permits inconsistent with the council’s planning scheme

• a failure to maintain adequate documentation evidencing the assessment process and planning decisions.

Community planning services were provided by an external provider without appropriate oversight by council to ensure these responsibilities were handled appropriately and in accordance with legislative requirements and the council’s planning scheme.

Glenelg Shire Council accepted the report’s findings and, prior to the tabling of the report, had taken action to improve the quality of its planning decisions.

UPCOMING REPORTS

Over the coming months, we intend to present the following reports for tabling in parliament:

• Follow-up of selected performance audits tabled in 2002 and 2003

• Report of the Auditor-General on the Finances of the State of Victoria 2004-05

• Results of 30 June 2005 financial statement audits and other audits.

Information on these reports can be found on our website at <www.audit.vic.gov.au >, then search under <audits in progress>.

PERFORMANCE REPORTING GUIDANCE

Those who continue to seek to improve the way they report to their communities are always looking for better ways to do so. Observing the good practice of others is one such way of doing so. A recent publication by the (United States of America) Governmental Accounting Standards Board (GASB) provides an update of activities in the USA.

Government Service Efforts and Accomplishments Performance Reports: A Guide to Understanding <www.gasb.org/pub/index.html>.

GAPS IN AUSTRALIAN GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAPS IN GAAP)

Introduction

The International Accounting Standards Board (IASB) is responsible for the development of International Financial Reporting Standards (IFRS), which focus on the “for-profit” sector. The Australian Accounting Standards Board (AASB) has responsibility for setting accounting standards for all types of reporting entities.

In implementing the Financial Reporting Council’s strategic direction for Australia to adopt international accounting standards, the AASB adopted the approach of issuing sector neutral standards by inserting “Aus” paragraphs in the Australian Equivalents to the International Financial Reporting Standards (A-IFRS) that deal, in the main, with the “not-for-profit” sector in Australia. The adoption of A-IFRS has, however, identified a number of areas where the standards do not fully meet the financial reporting requirements of the not-for-profit sector. Some of the more significant “gaps” are discussed below:

1. Distinguishing between “for-profit” and “not-for-profit” entities

There is currently a lack of guidance in A-IFRS for distinguishing between “for-profit” and “not-for-profit” entities in both the public and private sectors. As a consequence, various approaches for assessing “for-profit” and “not-for-profit” public sector entities have been adopted within different jurisdictions in Australia. The Australasian Council of Auditors-General (ACAG) and Heads of Treasury Accounting and Reporting Advisory Committee (HOTARAC) have separately developed guidance material to address this issue in the short term. However, further authoritative guidance should be developed by the standard setters to establish criteria to be used in classifying the status of an entity and the accounting treatments for the consolidation of not-for-profit and for-profit entities.

2. Accounting for “for-profit” entities that undertake activities that are for the public benefit

A-IFRS do not adequately address the issue of accounting for activities that are undertaken by “for-profit” entities for the public benefit. In the public sector, there are a number of state business corporations whose principal objective is the generation of profit, and are therefore classified as “for-profit” entities. However, these entities are very often required to undertake certain activities that are for the public benefit. Issues arise when the assets involved in such activities are assessed for impairment. Under A-IFRS, a “for-profit” entity must measure these assets at discounted cashflows, which is likely to result in substantial impairment losses, as in most cases, these activities do not generate adequate cashflows. This is also an issue when these for-profit entities are consolidated when the parent is a not-for-profit entity in that it is unclear as to whether such impairment losses should be reversed.

3. Promulgating standards for the reporting of non-financial performance

There are statutory requirements for some public sector entities to report non-financial performance. In some cases this information is required to be prepared in accordance with generally accepted accounting principles (GAAP), yet GAAP provides little guidance for such reporting.

Some Australian jurisdictions have introduced outputs and/or outcomes based budgeting and reporting, with financial reporting by outputs, and the setting of performance targets and reporting of non-financial information by output. Other jurisdictions have introduced requirements for reporting outcome based key performance indicators generally dealing with efficiency and effectiveness.

It is hoped that the AASB’s proposed standard on budget reporting in the public sector, including local government, and the expected International Public Sector Accounting Standards Board (IPSASB) exposure draft on reporting against budget will address this deficiency.

4. Determining appropriate parameters for when a “not-for-profit” entity controls another entity

Further clarification on the concept of control is required for public sector entities to produce relevant and meaningful consolidated financial statements. For example, there are issues in respect of:

• whether Australian Governments control universities

• the relationship between departments and statutory authorities within the portfolio

• the relationship between departments and corporations that are established to facilitate the operations of departments.

The situation will need greater clarification once the AASB withdraws AAS 27 Financial Reporting by Local Governments, AAS 29 Financial Reporting by Government Departments and AAS 31 Financial Reporting by Governments at which point, from a “control” and “consolidation” perspective, all reporting entities in Australia will have to comply with AASB 127 Consolidated and Separate Financial Statements. Clarity will also be needed in the finalisation of the proposed standard to be titled “Financial Reporting of General Government Sectors by Governments”.

5. Accounting for associates in the absence of Conventional Ownership Instruments

AASB 128 Investments in Associates requires an entity to equity account those entities over which it exercises significant influence. However, it is unclear how to determine the amounts to be equity accounted in situations where an investor does not hold conventional ownership instruments in another entity over which it exercises significant influence. AASB 128 either needs to be limited to investments in associates where there are conventional ownership instruments or further guidance should be provided to explain how to equity account for such investments in the absence of conventional ownership instruments.

6. Accounting for non-current physical assets

There are substantial non-current physical assets held by public sector entities, which include infrastructure and heritage/cultural assets. Issues needing attention include componentisation, revaluation, impairment and de-recognition of such assets.

It is of concern that AASB 116 Property Plant and Equipment permits entities managing significant infrastructure assets to report these assets on a cost basis, which over a relatively short period of time, will result in significant asset maintenance difficulties not becoming transparent. Mandating the adoption of fair values or current replacement cost for long-lived infrastructure assets, would provide more meaningful financial information.

There is currently a lack of guidance in the treatment of heritage and cultural assets. Difficulties in accounting for such assets include:

• the determination of appropriate valuation and valuation methodology

• the determination of useful lives and the meaning of depreciation

• heritage and cultural assets that appreciate in value over time.

The IPSASB’s project on this topic may result in guidance for application in Australia.

7. Accounting for intangible assets such as fishing quota and radio spectrum

AASB 138 Intangible Assets does not address situations where the Crown having established certain rights, such as fishing quotas or radio spectrum, subsequently retains some of those rights. AASB 138 does not provide guidance as to whether such intangible assets are considered as being internally generated, consequently, preventing the Crown from recognising those assets. Other examples include water rights and cadastral land databases.

8. Determining the appropriate accounting for Financial Instruments such as Interest Free Loans

Financial instruments such as interest free loans are not uncommon in the public and charitable sectors and it is important that consideration be given to the appropriate accounting for such financial instruments. AASB 139 Financial Instruments: Recognition and Measurement requires all financial assets to be initially recognised at fair value, meaning significant impairments could result in many instances.

Furthermore there are interest free loans provided to government entities with no fixed maturity date. In addition to the issue of having to recognise such loans at fair value on initial recognition, there is also the difficulty of determining the amortised cost of such financial instruments where the maturity date is unknown.

9. Accounting for Public Private Partnerships

There is currently a lack of guidance in accounting for Public Private Partnerships (PPPs). The interpretation committee of the IASB is currently developing an exposure draft on this issue for the private sector operator. As jurisdictions continue to embrace these arrangements as mechanisms to fund infrastructure projects, there is a need for the development of a standard dealing with the accounting for PPPs for the public sector to ensure that an appropriate and consistent treatment is adopted by both the private and public sectors.

10. Accounting for social obligations of governments

The Australian standard setters needs to maintain a watching brief on the work of the IPSASB regarding accounting for social obligations of governments. This issue is important not only in terms of accounting but in terms of accountability, as the public relies on the commitments that governments make, but which are subject to change depending on changing outcomes in the political arena.

11. Accounting for voluntary services

Services are provided on a voluntary basis in both the public sector and in the charitable sector. This issue is currently addressed by AAS 29, while A-IFRS is silent on and the issue. However with the proposed withdrawal of AAS 27, AAS 29 and AAS 31, it is important that the replacement standard(s) continues to include guidance to assist entities in determining when it is necessary to account for voluntary services received as revenue in an entity’s financial statements.

Concluding remarks

The public sector in Australia continues to support the AASB’s approach to issue sector neutral standards. However, as IFRS are developed with the private sector in mind, it is important that the AASB continues to develop accounting standards that address the specific issues and identified gaps in the accounting for the public sector.

SENIOR STAFF NEWS

• Edward Hay, Deputy Auditor-General, has taken permanent leadership of the Performance Audit Group.